Why Super Pro-rata Rights are Not a Good Deal for Entrepreneurs

Posted on Sep 25, 2011 | 35 comments


Yesterday I saw a Tweet from Chris Sacca fly by that prompted me to want to write a blog post helping entrepreneurs understand why they should push back against VCs asking for “super pro-rata” rights. I’ll explain what they are and why you should avoid them if you can.

A primer on “pro-rata” rights
Institutional investors will always insist on pro-rata rights. This is not something to be concerned about. All it says is that the VC has the right (but not obligation) to invest his/her proportional ownership in the next round of financing. Typically this means, for example, if the investor owns 20% of your company from the A round they have the right to take 20% of the next financing (and continue provided that this right survives the next financing).

There is a lot of confusion about how pro-rata rights are implemented as evidenced by this post by Seth Levine of Foundry Group.

Pro-rata rights are designed to protect investors from being diluted in future rounds of financing, which is an important way for VCs to protect the investments they make early that turn out to be super successful.

You can image if you were the A round investor in Zynga and saw it scaling quickly that you’d far rather put $5 million more into something that will obviously be a success than you would want to put that $5 million into a new, totally unproven deal.

So at the time that the initial VC funds you they’ll be thinking about protecting this right as depicted in the graphic below.

Obviously the situation is very different in companies where the company isn’t “killing it.” Pro-rata rights in these cases are normally exercised as a confidence building measure to ensure incoming investors that you still believe the company has upside. If you’re the A round investor you’ll often put in your pro-rata amount if required even though you might prefer not to.

If you’re invested $5 million to date and a new investor will put in another $5 million then in a sense that follow-on investor is protecting your initial investment by extending the runway of the company. Without them the initial investor has a choice of continuing to fund the company himself, letting it go bankrupt or trying to sell the assets and recover as much of his original investment as possible.

Putting $1 million into a new round to protect $5 million if new investors are willing to pick up the balance of the funding is often considered a smart bet.

In deals that aren’t hotly pursued new investors are looking for this support as depicted below.

Before explaining “super” pro-rata rights it’s important to understand the tension that often exists when you have a company performing very well and raising money from a large, brand name Silicon Valley investor. These investors often have internal policies that dictate that they own a minimum percentage of a company in which they invest. Of course every firm breaks its rules to get into a deal, but they put pressure on you by saying that they can’t.

“It’s 20% or nothing. That’s our firm’s policy”

I find that kind of black-and-white rule silly, but trust me people say it all the time. As though 18% of a big company is a terribly embarrassing outcome. Mostly I think the “minimum or we’re out” is just a strong-arm negotiating tactic.

So if you’re raising $10 million and only want to face 20% dilution and that’s the threshold for a new investor, you’re going to see tension. Why? Because existing investors will want to put their pro-rata money to work.

What are “super” pro-rata rights
So with this set up, what are “super” pro-rata rights? In the case of a super pro-rata right the investor (let’s say in your A round) will ask for MORE than their pro-rata right. They might own 8% of your company after the first funding but demand up to 33-50% of your next round of financing.

Why would this happen? Often it’s when a larger fund (e.g. non seed / micro VC fund) wants to put in $500k (less than their typical investment) but wants to have a marker on your company if you end up being super hot. In my mind, it’s almost like a dog pissing on its territory. Read: it’s an option for that investor and a super expensive one to you, the entrepreneur.

Why you should avoid super pro-rata rights
Why should you care? If they’re willing to put more than their percentage ownership why would I want to stop them?

Easy. You might make it difficult for you to get your company funded in the next round.

1. If you’re uber successful funding is never an issue. But if you’re reasonably successful such that the VC with super pro-rata rights wants to take his 50% of your new round and your other existing investors want to take their pro-rata rights, too, then there might not be enough for a new outside investor to feel motivated to write you a check. While I think steadfastly saying “20% or nothing” is silly, I do believe that new investors should own enough your your company to take the investment seriously.

So you’re stuck with an internal financing and no leverage to drive a fair price for yourself.

Note that the VC who had this super pro-rata “option” might have delivered tremendous value to your company and you might be OK with their taking a larger stake. They might have also done absolutely nothing and you’re now stuck with them owning more. They had a free option. You allowed it.

2. Consider the other scenario – where your company is doing OK but not amazing (e.g. the overwhelming majority of the time in early stage startups) and let’s say that the super pro-rata VC doesn’t exercise his right (remember, it’s a right, not an obligation to take more than his share). Now you’re forked. Remember the discussion above where the new investor is looking for the existing investor to take his pro-rata rights in order to prove that he’s confident in the business because existing investors have inside information.

Well, it’s far less likely that a VC marking his territory with a super pro-rata is likely to exercise that right if you’re not performing incredibly well. This same VC would almost certainly have taken his simple pro-rata investment. But the fact that he isn’t stepping up for more than his existing ownership despite having the right to do so is one big red flag for new investors.

How entrepreneur should talk to VCs about increasing ownership percentages over time
Simple.

First, you need to be clear that any larger fund writing a small check IS ONLY doing it so that they have the opportunity to invest at a later stage if you’re doing well. That’s why you don’t want a bunch of non-seed VCs taking small investments in you. It’s fine to have one. Often it’s a good idea. Two at a push. But if you’re “collecting logos” (as I warned about in this post) then I don’t feel sorry for you if you have tension at future financing rounds.

So here’s what I now say to every young company for which I write a sub-$500k small check to as part of a larger round,

“I want to be clear. I’m writing this check because I hope that I can lead your next round if you’re doing well.

I’m not asking for a commitment from you. If I prove that I’m a valued investor from now until your next financing I’m hoping you’ll give me extra consideration. But you’re not required to. I have to earn the right.

Equally, if you’re not performing well, I’m not committing now to lead your next round.

So each of us can be held accountable for our performance from here.”

If I were you I’d use this same line in reverse. Tell the VC that if they perform well and help you they’ll have a leg up on any outside investor but you obviously can’t guarantee anything. Equally tell them that you know that if you didn’t perform they obviously wouldn’t continue to invest. So you don’t feel comfortable with a free option now. Feel free to send them this post. The may not be happy with it, but it’s pretty hard for them to dispute this logic.

One warning I always like to make clear: when you have choices in life you can feel the luxury to follow my advice in this post. If you truly need the money and don’t have other choices, take the money. It’s not a terrible term to have super pro-rata rights in your deal. You’d just avoid it if you can. Anyway, it beats a swift kick in the arse.

Final Note: I know one team (and investor) that will be grimacing reading this post. Disclosure: I once had super pro-rata rights on a deal. It was extenuating circumstances, I personally wasn’t pushing for them, it left a bad taste in my mouth and I swore I’d never ask for them again. I think the CEO of that company would say that I did the honorable thing in the end on that deal. But I didn’t want to write this article without this small disclosure. Even VCs need to learn through mistakes.

  • http://twitter.com/siberianfruit Deena Varshavskaya

    Thanks for this, Mark! Very relevant post.

  • http://informationarbitrage.com/ infoarbitrage

    Mark, super interesting and relevant point, as usual.

    I will say that we at IA Ventures use a modest super pro rata right in one investment format: incubation. We are the only money in at that point, and have our position diluted down through option issuance in in the seed round. We also tend to view those situations as pretty binary – either the company doesn’t work and we lose our incubation capital, or the company looks promising, we step up and lead the seed round and exercise our super pro rata right (which is at a modest level, generally having us ending the round owning 20% fully diluted). After the seed round the super pro rata right goes away and we are left with a standard seed percentage ownership and clean terms. 

    As it relates to non-incubation situations, your position and messaging is almost exactly the same as ours. When we aren’t able to get to our target ownership percentage initially, we clearly communicate our desire to increase our stake to our partners, but work incredibly hard to prove our value such that we can either lead the next round or have an opportunity to buy-up via their support. There is no other way to do it: the relationship has to be grounded in trust and aligned interests, and there is no better way to do this than to earn your way into an enhanced position.

    My $.02.

  • http://bothsidesofthetable.com msuster

    I’m sorry for being dense. I re-read 3x and still don’t understand why it would be different in incubation investments? Do you mind elaborating?

  • http://about.me/austinlac Austin Clements

    Very clear explanation, I’m sure this will help a lot of people. Seems like more VCs are publicly speaking out to educate entrepreneurs on common practices of other VCs. What’s the motivation for this?

    I would assume it’s that you don’t want to have to pass on a good investment because poor decisions of an entrepreneur made in an earlier round, but it seems like there must be some other reason VCs are all of a sudden becoming more transparent about the implications of certain deal structures.

    May be just be coincidence, but I’m curious.

  • http://www.feld.com bfeld

    You beat me by a day. I saw Sacca’s tweet, replied with “Just say no to super pro-rata rights”, and drafted a post for Monday morning. Now that you’ve covered a lot of what I was going to cover, I’ll go edit mine to say “read Suster” + the other stuff that I was going to say.

  • http://informationarbitrage.com/ infoarbitrage

    So, in a situation where we are providing incubation capital for, say, 15% of the company (pre-option dilution, since no option pool is created at this time), we sometimes get the right to own 20% post the seed round. But in these situations it is 90%+ likely that if the company moves beyond the incubation stage, we are leading the seed round. This would be because the high-touch nature of the incubation relationship results in a mutual desire to continue working together with IA Ventures as lead. By definition, incubations take a disproportionate amount of time relative to straight early-stage investments, so we believe the 5% super pro rata right compensates us in the unlikely event that another firm leads the seed round. And even if they do, our owning 20% does not sufficiently stress the cap table and to preclude the company from taking lead financing from another firm.

    Agree or disagree, this is our logic.

  • http://www.wehelpyourock.com/ Mike Walsh

    great overview Mark – thanks.

  • http://www.feld.com bfeld

    Roger – having incubated many companies over the last 17 years, I think you are overoptimizing. If you doing a great job, you simply don’t need the pro-rata right in any scenario as the entrepreneur will always make sure you get what you want. Then – you can be a purist and say “super pro-rata rights are bad for the entrepreneur”, which by definition they are.

  • http://bothsidesofthetable.com msuster

    I want an entrepreneur for nearly a decade and have been a VC for 4 years. I still have a sense of wanting by brethren to be educated on issues so that they have symmetric data in dealing with VCs. Since I don’t intend to use trickery to own more of companies I figure the transparency should never hurt me.

  • http://bothsidesofthetable.com msuster

    LOL. Sorry. I was also going to publish on Monday (in order to not compete with NFL) but once I’ve written something I get too impatient to wait. If it’s any consolation – I re-read all of your posts on the topic before publishing to make sure I wasn’t missing anything. That’s where the Seth link came from.

  • http://informationarbitrage.com/ infoarbitrage

    You could be right. We’re still learning; I’ll take it under advisement. I understand your perspective and respect your experience. 

  • http://bothsidesofthetable.com msuster

    Whatever the outcome – for the record – I’ve never seen Roger NOT work hard for his ownership percentage. I can personally attest to this.

  • http://twitter.com/TMattCameron Matt Cameron

    Austin, without attempting to answer on Mark’s behalf, I would observe that VCs providing  such advice are actually advertising their integrity and and pragmatism, which will dramatically increase deal flow.  Mark’s writing provides us with a continuous stream of data points that we can use as inputs to assessing what it would be like to work with him and GRP.  

    As an entrepreneur, it is comforting to know who/what you are dealing with and the standards to which an investor holds themselves accountable.  For me, it is just like reading the ‘values’ that an employer puts in the employee handbook – You can always hold people accountable to publicly stated values, and this holds true for VCs asserting entrepreneur friendly practices – Which I would add are not one-sided because a truly good deal for an entrepreneur pays dividends for the investor who will get a loyal follower for future investments and deal referrals.

    Today I find VCs that are silent on important developments like anti-dilution practices are conspicuous – Given the choice between an opaque firm and a transparent one I think the choice to be obvious.

  • Gourav Soni

    Hey Mark
    We

  • http://www.feld.com bfeld

    I just re-wrote my post for Monday to highlight a few addition things. Hopefully you’ll get a nice traffic boost since you totally nailed this issue.

  • http://kWIQly.com James Ferguson @kWIQly

    What I really value from all three here is the open way you are sharing this – thanks

  • http://bothsidesofthetable.com msuster

    Thanks, Matt. And thanks for the card the other day. I thanked you publicly on Twitter. Hope you saw that but in case not, here’s a second “thank you” – was both thoughtful and funny

  • http://twitter.com/c_sheehan Chris Sheehan

    I look forward to reading your post!

     

    Mark, agree with Brad, you nailed it.  Great overview.  I’ve only ever used super pro rata in one
    financing and immediately took it out on the next round, which we led as an
    insider.  

  • http://bothsidesofthetable.com msuster

    That’s called a “tranched investment” and is not an uncommon practice although I usually discourage milestone-based investments except in extreme scenarios (like somebody asking for an extremely high valuation). 

    As with everything else – if you have choices I’d avoid that deal for sure. If you don’t, it’s not terrible. If they’re the only investor you night just try to negotiate:
    – in the first instance for the right to be removed
    – in the second instance for it to stay in but at a higher price or if nothing else then
    – your ability to not accept the second tranche of you don’t want. At least then if you’re performing well you can shop it around

  • http://twitter.com/jimandelman Jim Andelman

    Gourav, IMO a tranched investment is a bad idea.  The odds of that second tranche being “appropriately priced” is very low (i.e. exactly fair market value — valuation at which you could raise that amount from an outsider — at the time it’s due.  If “fmv” is below that valuation, they won’t put the money in and you could get caught in a pinch.  If the “fmv” is above that valuation, you’ll be giving away more of your company than you should for a given amount of cash, and it may cause disharmony.

    Like Mark said, if you have no other choice and therefore no negotiating power, funding is probably better than no funding, so accept it.  But try hard to get rid of that structure.

    For argument’s sake, you can use an option pricing model to ballpark the “value” of the option they are asking for.  Then just ask them to pay cash for it.  :)

  • Anonymous

    Anything that gives more negative signaling opportunities and doesn’t give me an upside seems like a bad idea to me.

  • http://arnoldwaldstein.com awaldstein

    Super useful Mark. Thanks!

  • mcody, president Cellar Angels

    Mark-
    I’ve learned something from every post I’ve read in the last six months.  Thank you for the insight, intellect, humor and honesty in all that you do.  Great post, soon to be very relevant and much appreciated.  Cheers.

  • JamesHRH

    +1. An excellent review of both sides of the table on this issue.

  • http://www.alearningaday.com Rohan Rajiv

    I see Brad Feld linked this one as well. Loved the dog pissing on his territory analogy!

  • http://autoaccessoriesgarage.com Jared McKiernan

    Mark – Why exactly is it that pro-rata rights exist in the first place? I don’t quite understand why, when you put in a certain amount of money for a percentage of the company, more money must be added later to retain this right? Why is this the case?

  • http://www.mealdrop.com Michael Zaro

    I completely agree James. There are few places where us entrepreneurs (who are learning/improving every day) get to see that the big-shot VCs we hope to work with are doing the same. 
    Mark, that is one of my favorite things about your posts, how open you are about the investment process and your experiences both positive and negative. It’s incredibly refreshing.

  • http://www.mealdrop.com Michael Zaro

    Adding more money isn’t necessary. But when new investors come in, old investors get diluted along with the founders. If the earlier investors want to avoid dilution, they can negotiate for the right to re-invest a percentage of the next round in order to stay “at par” for their ownership stake. Like Mark said, super-pro-rata rights would allow the earlier investor to not only maintain their share, but also increase their ownership exclusively at their option.  Hope that helps.

  • http://autoaccessoriesgarage.com Jared McKiernan

    My question is more “why is this the case?”  – I don’t really understand why anyone should get diluted when new investors come in, based on dilution when an existing investor owns a % of the company, they only own it provided they continue to invest based on their pro-rata. Why do they have to do this? It seems to needlessly complicate things.

  • http://www.mealdrop.com Michael Zaro

    Here’s a super simple example for Company A.

    the founder has 10 shares of stock. Initially that’s 10 out of a possible 10 so he owns 100%

    When he takes his first round of funding he doesn’t give the investor his shares. Instead the company issues an additional 5 shares. So the founder now has 10 out of a total 15 for 67% ownership and the investor has 5 of 15 for the other 33%. The founder has been diluted.

    When the second round of funding comes the company creates 5 more shares for the 2nd investor. So the founder is further diluted to 50% because he owns 10 of the 20 total shares. The second investor now owns 25%.  In this case the 1st investor gets diluted from 33% (5/15) to 25% (5/20). Pro-rata rights means that the 1st investor would have the right to re-invest some money and buy 1.7 shares so his total would be 6.7 and he would get back to his 33% (6.7/20) to keep from being diluted.

  • http://termpaperwriter.org/ research paper

    Amazing stuff,Thanks so much for this!This is very useful post for me. This will absolutely going to help me in my projects .

  • http://startupgrowthexpert.com/ Vinil Ramdev

    whether there is a pro-rata or a super pro-rata clause in the term sheet or not, end of the day the entrepreneur and the investor need to be comfortable with each other. As an entrepreneur, I don’t mind the super pro-rata as long as I am comfortable with the investor but yes as the article says, it’s always better to have options.

  • Ma

    So is this what happened to the co founder of Facebook when he got left with diluted shares at the end that were barely worth anything? (according to the movie) Interesting article – the topic mimics other negotiations in life.

  • http://twitter.com/nglaros Nicole Glaros

    Thanks Mark.  Good advice, simple explanation – already helping some of the TechStars companies!

  • http://www.bodhost.com/dedicated-server-hosting.shtml Dedicated Server Hosting

    I think, entrepreneur should prefer investors who make it a policy of maintaining their percent possession in the next round. This incentivize them to increase the next round’s valuation. And usually these kind of an investors don’t try to increase their percent on possession, because they aware that it puts them at odds with the founders and management. Also they are aware it incentivize them to use their protective provisions to veto good offers. They know it forces them to point their sense of the correct valuation.